Spin cycle

New Claymore ETF targets spin-offs in quest to beat market

By

JohnSpence

This update of a column originally published Dec. 17 corrects the name of Al Cardilli, analyst at investment-research firm Spin-off Advisors LLC.

BOSTON (MarketWatch) -- For some investors, corporate spin-offs attract about as much interest as the short-lived "Happy Days" offshoot "Joanie Loves Chachi." However, the backers of a new exchange-traded fund say investing in a basket of spin-offs can deliver market-beating performance.

The theory is inefficiencies exist in the market that can be exploited because an overly pessimistic Wall Street often views the new companies as troubled orphans. Meanwhile, the spin-off's management, free of the parent company, has greater incentive and is able to focus more on growing the business.

The Claymore/Clear Spin-Off ETF
CSD, +0.23%
began trading last week on the American Stock Exchange, one of four offerings launched by ETF up-and-comer Claymore Securities Inc. of Lisle, Ill.

The fund tracks an index of spin-offs from New York-based custom-benchmark creator Clear Indexes LLC.

A spin-off is a new company that's formed when a conglomerate sells stock in a subsidiary. Recent examples include American Express Co.
AXP, -0.25%
splitting off its wealth-management unit Ameriprise Financial Inc.
AMP, -1.05%
to focus on its core credit-card business, and Viacom Inc.
VIA, +0.12%
spinning off CBS Corp.
CBS, -0.74%

"Spun-off or carved-out companies have the flexibility to execute what's best for their businesses, as opposed to what's best for the corporate parent," said Clear Indexes Chief Executive Andrew Corn in an e-mail last week.

"In addition, compensation is directly aligned with the performance of the business, not watered down or influenced by the parent company," he added. "This gives everyone a stronger incentive to perform."

Indexing spin-offs

Companies eligible for the new ETF's somewhat quirky index must have been spun off within the previous two years, but their stock must have been trading for at least six months. This starting batch is then whittled down to a fixed 40 stocks, each capped at a maximum 5% of the portfolio.

Most of the holdings are small and midsize stocks with market capitalizations under $10 billion, according to the prospectus. The index selects stocks and rebalances the portfolio semiannually. Top index holdings as of Nov. 30 included Discovery Holding Co.
DISCA, -1.10%
Expedia Inc.
EXPE, +0.83%
and Genworth Financial Inc.
GNW, +0.58%

So-called carve-outs, where a parent company sells only part of a subsidiary to the public and keeps the rest, are also included in the tracking index, which has at least a whiff of active management because Clear uses a quantitative model to overweight the "best" stocks.

Fees for the new ETF are currently capped at 0.6% of assets, said David Cohen, Claymore's managing director of product development. The firm now manages nine ETFs, not including a new pair of ETF-like vehicles designed to track crude oil prices. See previous ETF Investing.

Claymore sponsors ETFs that arguably have some of the most "active" strategies built into the tracking indexes, including a "stealth" fund targeting unloved companies and a sector-rotation ETF. See related story.

As the impetus for the spin-off ETF, Clear, the index manager, cited a Lehman Brothers study published in February that determined the average two-year gain on spin-offs from 2000 to 2005 was 45% higher than the stock market as measured by the S&P 500 Index
SPX, +0.36%

A Goldman Sachs report earlier this year found that consistent with past studies, spin-offs executed between 2000 and 2005 generally tended to outperform the S&P 500. However, Goldman found spin-offs tend to lag the market in the first weeks and months after regular trading in the shares begins.

This is partly why Clear opted to wait six months before adding new spin-offs to the benchmark.

"Spin-offs don't outperform right away," said Corn, the CEO.

One reason is that unlike the bubbling IPO market, spin-offs don't draw a lot of coverage from Wall Street analysts, he explained. Also, units that are spun off are often troubled by debt or legal problems.

Finally, shareholders in the parent company who receive stock in the spin-off often sell right off the bat, which may curb demand, although Corn said he doesn't see evidence that influences performance. Companies can stay in the index for a maximum of two years, which Corn defines as the "expiration date" when a company is no longer considered a true spin-off.

Active debate

Al Cardilli, analyst at investment-research firm Spin-Off Advisors LLC, said there's academic research going back 20 years showing the outperformance of spin-offs.

His explanation of the trend is that management doesn't have to worry about the oftentimes disparate businesses of the parent company. Additionally, incentive is higher because workers can see their labor more reflected in results, and perhaps more importantly in the stock price.

"People who own stock and options in the company see their efforts as more transparent in the stock price, and money is a great motivator," Cardilli said.

Yet some fear the spin-off ETF and other new offerings could leave some investors feeling dizzy. There's a rising chorus that says the rapid-fire launches of ETF products are getting out of control, and that some rely too much on theoretical, back-tested performance.

"It seems like some of these exotic new ETFs are really scraping the bottom of the barrel," said Mark Hulbert, publisher of Hulbert Financial Digest, a service of MarketWatch.

The individual parts of a company aren't always worth more than the sum, especially when companies are broken up after the market goes through an M&A binge, Hulbert said. He worries the approach "paints a broad brushstroke based on historical performance that might not always be the case."

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